Executive Compensation: A Practitioner Discusses §409A And Some Of The Other Current Issues

Editor: Mr. Marathas, I understand that you have joined Proskauer's Boston office recently. Would you share with us your thoughts on why Boston is such an important market for the firm's executive compensation and employee benefits practice?

Marathas: Proskauer's executive compensation and employee benefits practice is one of the oldest in the country and, I believe, among those with the highest reputation. Over the years it has been based in New York. That is changing. Reaching out to places such as Boston and Los Angeles is a reflection of the firm's continuing growth in this area and a recognition that the highest quality of executive compensation work is not necessarily confined to New York.

With respect to Boston particularly, this city is thriving in a great many economic sectors, including financial services, high-tech and biotech, and medical technology. All of these sectors have a need for legal services, not the least of which are those services which relate to executive compensation. If any question about Boston as a market for legal services existed, we need only point to the fact that Proskauer Rose's Boston office has grown from three attorneys to more than 105 in just a few years.

Editor: You have spoken about the trend of executives being terminated for cause in order to limit severance packages. Is this something new?

Marathas: It is something new. Increasingly, as the economy has slowed over the past 12 to 18 months, employers have shown a willingness to take a hard look at employment agreements in connection with the termination of an executive. In the past, there was an inclination to avoid a public fight and possible negative publicity as well as incur litigation expenses and the lost opportunity expenses associated with litigation. That meant paying the executive off, sometimes quite extravagantly. Very often that is not happening today. If the employer believes that there is some justification for termination for cause, an attorney is brought in to renegotiate the severance provisions of the executive's employment agreement, and that usually means that the executive is going to leave with considerably less than he or she would have received under the employment agreement in the absence of cause. Among the factors contributing to this state of affairs, in addition to an increasingly poor economy, is an enhanced interest on the part of shareholders and the investing public in how companies are compensating their executives. For a variety of reasons, then, employers appear to be much more willing to draw the line than they were in the past.

Editor: What does a typical - if there is such a thing - severance package cover today?

Marathas: There are a number of standard provisions that you will find in just about any severance package. Often, however, there are issues which are not dealt with, or not dealt with clearly, in severance arrangements that can cause a great deal of trouble. For example, how are bonuses dealt with in the severance package? This is a crucial issue because the IRS now says that the application of §162(m) of the Internal Revenue Code may cost the employer (if it is a public company) the deduction of bonus amounts paid out as severance. Similarly, equity-based compensation payments, deferred or otherwise, may be affected by severance. Do they vest? Do they accelerate? Does the employer have a right to call the stock in a private company? These things may not have been originally addressed when the employment contract was signed, but they certainly must be addressed when the executive is terminating. And non-compete clauses, non-solicitation clauses and provisions dealing with confidentiality may appear in severance agreements even if they did not appear in the original contract of employment.

Editor: Speaking of deferred compensation, you have been following the discussion on §409A of the Internal Revenue Code with some care. Please give us the background on this statute.

Marathas: My personal opinion is that Congress used a sledge hammer when they would have done better to use a sculptor's hammer. It was enacted in 2004 in the wake of Enron and similar scandals, which left shareholders holding worthless stock while the executives walked away from the company with what remained of the company's cash. For more than 20 years the IRS and Treasury had been telling Congress that they needed some sort of statutory authority to police the area of non-qualified deferred compensation. As a consequence of a lack of regulation, some very aggressive lawyers argued for, and often obtained, deferred compensation arrangements for their clients that were quite extraordinary. Some of these arrangements constituted nothing less than a financial trigger permitting the executives, in the event the company was encountering adversity, to clean out all the cash and depart before the company collapsed. Enron and the other scandals provided the IRS and Treasury with an opportunity to convince Congress that it was time to address the matter with some very broad legislation and to effectively invite them, the IRS and Treasury, to the party.

Editor: I gather the statute covers arrangements that were not considered deferred compensation in the past.

Marathas: In the past what was considered non-qualified deferred compensation was pretty straightforward. An executive would be subject to an arrangement that promised him $200,000, $100,000 immediately and the other $100,000 in five years, provided he or she was in the employ of the company at that time. Everyone agreed that such an arrangement constituted non-qualified deferred compensation. Another form of deferred compensation was the supplemental executive retirement plan - the SERP - which made essentially the same promise but linked to the company's qualified retirement plan and permitted the executive to obtain more money than would be available from the retirement plan.

Under §409A, any promise made during one tax year to pay an individual something in a later tax year may be considered deferred compensation for purposes of §409A. A promise to pay severance, for example, is deferred compensation. And stock options, which no one really thought of as deferred compensation, are drawn into this statutory framework unless they are granted with an exercise price at fair market value and have no other deferral features. That, of course, raised considerable problems in connection with the backdating of options, which caused a considerable furor recently. Any option granted at an exercise price below fair market value at the time of the grant is subject to §409A.

Editor: What does §409A require?

Marathas: The statute includes some very specific rules with respect to elections to, and distributions of, deferred compensation. The company can make a distribution from a non-qualified deferred compensation arrangement at the time of a separation from service on a specific date or any certain tax year, on a change of control of the company, as defined in the statute, and on death, disability or unforeseeable emergency.

The whole idea of an option, of course, is to give the executive some choice as to when he is going to exercise his rights to benefit from the sale of the stock. If the option is subject to §409A, it becomes exercisable on, say, a separation from service, but that may be precisely the time when the fair market value of the stock is below the option price. In that situation, the option has no value. An option subject to §409A loses its key intrinsic value: the executive's ability to exercise when it is at its greatest value.

Editor: What is the effective date for full compliance?

Marathas: Any company with an arrangement that is subject to §409A must be operating in accordance with the requirements of the statute now. Documentary compliance is required by December 31, 2008.

Editor: And the penalties for non-compliance?

Marathas: Penalties fall on the executive primarily. First, there is the 20 percent excise tax on the deferred amount, and this is over and above the regular income tax, plus interest from the date that the IRS determines that the individual had a right to the payment. The executive might not be audited for several years after the vesting date, and if you think of the regular income tax, the excise tax and the interest going forward, you would not be too far out of line to think the game not worth the candle.

When the statute was first enacted, a number of general counsel took the line that this was a problem for the executives, not the company. I think that is short-sighted. The company has an interest in having an effective compensation program and executives who are focused on the company's affairs, not on potential IRS audit problems. Both the company and senior management have an interest in seeing that these deferred compensation arrangements are in operational compliance now and in full documentary compliance by the end of the year.

Editor: You have also been following the increase in shareholder attention to executive compensation matters, including "say on pay." What is driving this issue?

Marathas: The media has been full of stories about excessive compensation in recent years, and that has to be a factor in the increase of shareholder interest in this matter. The new SEC disclosure rules on compensation are one of the results of enhanced shareholder interest, but of course those rules are themselves feeding that interest because they serve to provide the shareholders with information that, until recently, may have been confined to the boardroom.

With respect to "say on pay," many commentators believe that to permit shareholders to make decisions on executive compensation is an unwarranted intrusion on the people entrusted to run the company. They add that if the shareholders do not like what the directors are doing, they have an opportunity to elect their own slate of directors. My own view is that "say on pay" is interesting, but that it is going to have much less of an impact on executive compensation than the implementation of the SEC disclosure rules. I believe that the latter have had a very salutary effect on the process that compensation committees and boards of directors go through in setting executive compensation. I have worked with such groups for many years, and I do not think that process - by which I mean coming to meetings fully briefed on the materials under discussion, participating in a careful and comprehensive discussion of the issues and having those deliberations properly documented in minutes by those qualified to draft minutes - has ever been as important as it is today. If the corporate scandals earlier this decade have led to such a state of affairs, then I think we can say some good came out of a very bad situation. I think, in addition, that the SEC has done a very good job in developing compensation disclosure rules that benefit everyone, the shareholders and the investing public, boards of directors and their compensation committees and the corporate executives who are the direct beneficiaries of these compensation arrangements.